Summary

Most financial advisors simply stick their clients into a 60/40 portfolio or some mix of stocks and bonds.

Over the past 3 decades, this strategy has worked very well.

We have concerns that the 60/40 portfolio's time has come, as we possibly re-enter a period of stagflation.

The 60/40 (60% stocks, 40% bonds) portfolio is the way most wealth advisors allocate money. It is easy and has worked for the last 40 years. But will it work in the future?

We are firm believers that the strategy may be fatally flawed during the next recession. During periods of volatility and bear markets, the bonds cushion the portfolio reducing the downward movement. In 2008, the Barclays U.S. Aggregate Index was up 5.88% aided by increasing prices for safe-haven investments like Treasuries.

Over the past three decades, we have seen the Fed officials reduce interest rates to stimulate growth while increasing rates to combat rising inflation. But problems arise if they have to do BOTH at the same time.

The issue could be the return of 1970s-style stagflation. That is, slowing growth coupled with rising inflation. At that time, it was a credit boom from baby boomers at the same time that we had two oil crises boosting prices and input costs.

Today, it is tariffs and trade wars, rising commodity prices, and slowing global growth mainly centered in Europe and Japan. The Citigroup Surprise Index is mean-reverting so we often see downturns in the metric without a recession.

The 10- and 30-year Treasury bonds are supply and demand driven influenced by, among other things, inflation and growth expectations. It wouldn't surprise us if we see a slowdown and no movement in the 10-year due to offsetting rising inflation expectations, along with significantly rising issuance to fund the budget deficit.

The early part of 2018 telegraphed some of what we think will be happening more and more in coming quarters - bond prices and stock prices moving in the same direction, especially during periods of downside volatility. In February, the S&P 500 fell slightly more than 10% from its highs set on January 26th, at the same time bonds sold off.

Rising Inflation Expectations

Inflation potential is clearly rising. We typically see more significant inflation when wages start rising, above 4% yoy. On April 30, the employment cost index rose to hit the highest level since 2003 indicating wages are set to rise significantly.

Since the financial crisis, one of the drivers of the lack of inflation has been the falling velocity of money. But for the first time since 2010, the figure is no longer falling.

We also see PCE services inflation grow by the highest percentage since the financial crisis.

As is typical late in the business cycle, we are also seeing a spike in commodity prices. We closely watch the price of specific metals and agricultural products. Those input costs get filtered through the wholesale economy first and then to consumer prices.

That is evident in the recent ISM Manufacturing prices paid index rising to the highest levels since 2011.

Slowing Global Growth

While manufacturing in most big economies is still expanding, the pace of those gains has slowed noticeably in recent months. Meanwhile, key industrial commodities like copper and aluminum also started selling off in late 2017, well before trade worries started spooking markets.

The implication: The strong global manufacturing rebound evident since late 2016 may have already-or be close to-peaking, whether or not a true trade war erupts.

Slowing momentum in China has been evident for months. A modest bounce after February's Chinese New Year notwithstanding, China's official manufacturing Purchasing Managers' Index appears to have peaked in the third quarter of last year, while Caixin's alternative index has also trended sideways since then.

Europe's PMI is down 4 points since December although it is still in expansion territory.

In the U.S., first-quarter GDP came in at 2.3%, after early expectations for it were in excess of 5%. Second quarter looks to have similarly lofty expectations above 4%. While a recession looks to be a ways off, the boost we saw from the bear market in early 2016 clearly appears to be waning.

The 60-40 Portfolio

As we noted above, we think this portfolio's time has passed. During the past nine years, rising asset prices lifted both stocks and bonds simultaneously. As future correlations, volatility, and returns change given the current shifting market environment, so too should advisors' approach to asset allocation.

Modern portfolio theory is built on the fact that a multi-asset portfolio comprised of non-correlated assets sees a diversification benefit increasing returns per unit of risk. But if the correlations of these assets increase, then a spike in inflation coupled with slowing growth would smack equity prices while sending bond prices lower at the same time.

I decided to run some numbers to show the effects on performance from the massive bond bull. I've broken up the annual returns for a 60/40 portfolio made up of the S&P 500 and 10 year treasuries by two very different periods. From 1948-1981, interest rates were rising from very low levels. The 10 year yield was 2.4% at the start of 1948 and didn't stay above 4.0% until 1963, 15 years later. The second period from 1982-2014 is the falling rate environment everyone is now well aware of.

Here are the annual returns:

The period during a rising rate environment saw the 60/40 portfolio underperform by nearly 3%. Add in an expensive equity market and we believe we are likely to see returns much closer to 5-6% for the portfolio over the next 10 years compared to the 8-10% realized during either previous period. Over longer periods of time, it may be higher. However, we currently have the baby-boomers retiring at a fast rate (10K per day) and the early years of retirements are the most critical to not outliving your assets.

We think we are fast-approaching a retirement crisis as a paradigm shift in future returns and correlations makes obsolete this set-it-and-forget-it portfolio construction technique. Financial advisors had it made. Select a mix of stocks and bonds commensurate with the risk tolerance of the client - typically between 50-50 and 80-20 (with most 60-40). Pick a few mutual funds and ETFs to fulfill that asset allocation. Rebalance once or twice a year. Have an annual review with the client. Collect a 1% annual fee for doing so.

If your financial advisor fits into that mold, we would highly recommend having a conversation with them.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.